Lots of people are accustomed to the idea of taking out loans, borrowing money or accessing credit for a small business — but beyond the simple aspects of interest rates, loan amounts, repayment terms and other basic details of taking out a loan, many people might not understand the concept of loan amortization.
Loan amortization is a crucially important concept to understand if you are borrowing money for your business. The loan amortization schedule helps determine how much total interest you will pay over the life of a loan, and also shows you how soon your loan will be repaid.
If you want to really know the details of your business’s financial wellness, you need to understand loan amortization.
Here is a big picture guide to loan amortization and why it matters to your business.
What Is Loan Amortization?
Loan amortization is the process of breaking down a loan into fixed payments over a specified period of time. With an amortized loan, you repay the loan in a total fixed payment each month. But within that total payment amount, you are paying different amounts of interest (the amount of “extra” money that you pay to the bank or lender as their profit) and principal (the actual “face value” amount of money that you borrowed).
The amount of interest that you pay as part of your total payment amount each month will decrease over time. Depending on the specific details of the loan, the first few payments on the loan will be mostly interest, and the last few payments on the loan will be mostly principal.
Some common types of loans that are amortized are mortgage payments and car loans. Business loans can also be amortized if the loan is a fixed-term loan that is being paid off according to a fixed schedule. An amortized loan is different from a business line of credit, where the business has more flexibility in how much of their available credit they use or repay each month.
What's a Loan Amortization Schedule?
If you borrow money for your business, the lender should provide you with a loan amortization schedule. This is a chart that shows a specific breakdown of how many payments you will make over the life of the loan, how much interest and principal will be included with each of those fixed payments, how much money is still owed on the balance of the loan after making each payment and how much total interest you will pay during the term of the loan.
If you do not receive a loan amortization schedule as part of the information given to you with your loan, you can create your own schedule with an online loan amortization calculator.
For example, if you borrow $50,000 for your business and agree to pay it back over 10 years at 5% interest, your loan amortization schedule would include 120 payments, a monthly principal and interest payment of $530 and total payments of $63,639 over 10 years — meaning you will pay $13,639 of interest on that $50,000 loan.
Benefits of Understanding Loan Amortization
Understanding loan amortization helps you see the full costs of borrowing and gives you better visibility into how much interest you are paying on your loans. If you see just how much interest you’re paying each month and over the life of a loan, it can sometimes give you better clarity into which loans to pay off first, which loans to refinance or which loans to pay off faster.
Sometimes people are eager to sign up for a loan based on the interest rate or the monthly payment amount, without realizing what that monthly payment really includes. If you can see the full interest amounts that you’re paying each month, this can help you make smarter decisions about borrowing and financing your business.
Monthly payment amounts vary depending on the interest rate of a loan and the term of a loan. If you make the term of a loan longer, this can give you a lower monthly payment, but you will pay more total interest over the life of the loan.
Your business needs might change during the life of a loan, too. Don’t assume that just because one financing option has a higher interest rate or higher interest amounts in the monthly payment, that means it’s “bad” for your business. You might want a lower monthly payment upfront with a longer term, even if you’re scheduled to pay a lot more interest. But in a few years as your business grows, you might be able to pay off the loan more quickly.
Things can change quickly in business finance; sometimes it’s better to give your business more flexibility and reduce your monthly expenses in the short run, and pay off your loans more quickly in a couple of years when your cash flow has (hopefully) improved.
Loan Amortization Calculators
There are several free online loan amortization calculators. Here are a few good ones:
Understanding loan amortization will help you make better-informed decisions about when and how to borrow for your business. Remember: There is more to a loan than the interest rate or the monthly payment.
Depending on the terms of your loan, you might end up paying more interest than you had realized. Make sure that your loans are the right fit for your business’s financial needs, today and into the future as your business evolves.
Ben Gran is a freelance writer from Des Moines, Iowa. Ben has written for Fortune 500 companies, the Governor of Iowa (who now serves as U.S. Secretary of Agriculture), the U.S. Secretary of the Navy, and many corporate clients. He writes about entrepreneurship, technology, food and other areas of great personal interest.